Likes:
$2.94/diluted share in cash
$2.12/diluted share of cash net of all liabilities
$3.74/diluted share of Current assets net of all liabilities
Dislikes:
Relatively new entity
Copper is at a high – therefore they are unproven during times of lower prices
China is trying to tame inflation
Growth based on low margin business
About the Business:
Lihua International, Inc. manufactures and sells cable, wire and refined copper products in the Peoples Republic of China. It develops, designs, manufactures, markets, and distributes alternatives to pure copper wire, which includes copper clad aluminum wire and recycled scrap copper wire. The company is based in Danyang City, the People's Republic of China. As opposed to mining copper and producing copper products for re-sale they recycle copper and since it is not pure copper is much cheaper to produce and costs less to end users. This is particularly interesting since commodity prices, including copper, are so high. Additionally, the copper product in China has strong demand. Without getting into the details of how this works and the proprietary processes Lihua uses to produce their copper products (which can be reviewed at Lihua's website) let's get into why this may be a good value investment.
Balance Sheet:
As of December 31, 2010 (using fully diluted shares of approximately 30,800,000 including warrants) there is approximately $2.94 per share of cash on the balance sheet. In fact, total current assets are 4.55 per share. On the liability side of the balance sheet, total liabilities are just over $25 million with no long term debt. Therefore, cash net of all liabilities amount to $2.12 per share and current assets net of all liabilities is $3.74 per share. Therefore, we essentially get the business for $4.08 per share (based on the 4/15/11 close price of 7.82). Even if we conservatively say that the receivables (1.07 on a per share basis) are worthless, the business costs us $5.15 per share which is 3.99 times 2010 fully diluted earnings.
I am not taking into consideration any of the property, plant and equipment because the land is leased from the PRC and their machinery is custom made, thereby it appears the long-term assets are only worth the money they produce. So, let's take a look at the income statement.
Income Statement:
Sales have grown from approximately 50,000,000 in 2008 to 370,531,000 as of December 31, 2010 or 740%. Net income over this time has increased from 14,197,000 to 54,296,000 or 282%. Although shares issued and outstanding are 29,968,087 the fully diluted shares are approx. 30,800,000. 2010 net income translates to just under $1.29 per share on a fully diluted basis or 6.06 times earnings based on Friday April 15, 2010 closing price ($7.82). Further, the 4th quarter was the first including revenue from their recently-launched copper anode product line which totaled 26% of full year sales. They further received 2011 copper anode volume orders of 54,000 tons and an additional indication of demand from three additional customers for total demand of 80,000 tons. Problem is this exceeds current capacity. Good news is the recently launched production of a second copper smelter doubled capacity to 50,000 tons and Lihua additionally broke ground on a second smelting facility which is expected to be completed in 2H11 which will double capacity again to 100,000 tons.
Let's take a quick look at future growth. Currently, 2010 production capacity and Gross Profit was as
2010 2011 Copper Anode 50,000 100,000 CCA Wire 7,500 7,500 Copper Wire 20,000 20,000
Gross Profit GP % Copper anode 50,933,000 20.95% CCA Wire 8,507,000 8.71% Copper rod 2,661,000 8.93% Total 62,101,000
Keep in mind 25,000 tons of capacity for the copper anode came online during 2010 and another 50,000 tons of capacity is scheduled to come online is 2011. Therefore gross profit can increase by almost another $1 per share in earnings based on gross profit for the copper anode having earned $8.5M since August of 2010. Lihua has a couple of things going for it: (1) Increasing earnings and (2)a re-evaluation by the market on the valuation of the company, for instance, an increase in the P/E . At 10x earnings of $2 = $20/share ($1 of current earnings plus $1 as calculated above due to an increase in output from newly constructed assets).
Other than an increase in earnings the catalyst or the reason Lihua is so cheap is due to the way Lihua raised money. Lihua completed a reverse-merger with a public shell corporation. According to recent articles several Chinese companies have raised money this way and some are being investigated by the SEC for fraud. Therefore a stigma around these companies has driven down prices for many companies that raised money through a reverse merger. Therefore, the biggest risk is that the company is committing fraud makes no money and the entire investment wiped out.
That being said a couple of the ways a company commits fraud is through booking sales that do not exist or for sales to related parties. In either case, such fraudulent sales typically would show up as accounts receivable because such fraudulent sales would not translate into cash. Another possibility is that the cash booked on the balance sheet is overstated and fraudulent. I am sure there are other ways these are just a couple of ideas. However, the first procedure an auditor performs is through confirming cash balances with the banks. Therefore, unless the auditing firm is also committing fraud the cash on the balance sheet should actually exist.
Two things that I can think that may mitigate our risk with Lihua. The first is whether or not the auditor is reputable. The former auditing firm for Lihua was AGCA. I took a look at the "Inspection of AGCA" completed by the PCAOB who found deficiencies in AGCA's procedures related to accounts receivable and inventory valuation. This does not mean they were wrong it just means their auditing procedures performed were deficient in substantiating the value of these accounts. Additionally, if you look up other prominent accounting firms such as any of the Big 4 they also have similar types of deficiencies. At this point there does not seem to be a reason to doubt that the firm is reputable. The current auditing firm is Crowe Hogarth. Crowe Hogarth is a top 10 accounting firm. I took a look at the "Inspection of Crowe Hogarth" completed by the PCAOB and found similar results. It is hard to believe a firm completing fraud would make this type of move. Not that top accounting firms have not committed fraud in the past (think Enron and Arthur Anderson) but auditing standards are quite a bit more stringent now.
The second way we may be able to mitigate our risk is to take a look at accounts receivable in relation to sales. In other words, are the sales generating cash or are they only generating receivables. Total A/R net of the allowance for doubtful accounts (of zero) totals $0.82 of the share price. Even if all of the current net a/r on the balance sheet is fraudulent and these sales are deducted from full year sales and taken out of the product with the highest gross profit (copper and CCA wire) their net income would drop to roughly 8 million instead of $38.8 million. It seems either way they are at least making money, negating the risk that the entire investment would be wiped out. A .25 per share net income at 10x earnings would translate into a price of $2.50 per share based on earnings alone. Therefore, downside risk appears limited to $5.00 per share (current price less $2.50).
I would like to point out one additional analysis. I did not talk much about cash flow. The reason is the cash flow analysis per share I ran based on earnings less depreciation and amortization plus capital expenditures, for 2010, came out the same per diluted share as the earnings per share. This is in part due to a $9m payment to the PRC for a 50 year lease of land for the new smelting plant. Take out this $9m payment which is going to be amortized over the next 50 years will add another 0.25 per share of cash flow (35m diluted shared divided by $9m). As much cash as these plants appear to be generating free cash flow going forward should continue to increase as well.
Finally, there are some short sellers that have outlined why they believe Lihua is committing fraud. I will discuss such analysis in the next blog.
Disclosure: I, own shares of Lihua International, Inc. (LIWA, Financial). This report is not a solicitation to buy or sell securities. We are not responsible for any losses resulting from purchasing or disposing shares of Lihua International, INC (LIWA). You are advised to consult your financial advisor or conduct the due diligence yourself.
$2.94/diluted share in cash
$2.12/diluted share of cash net of all liabilities
$3.74/diluted share of Current assets net of all liabilities
Dislikes:
Relatively new entity
Copper is at a high – therefore they are unproven during times of lower prices
China is trying to tame inflation
Growth based on low margin business
About the Business:
Lihua International, Inc. manufactures and sells cable, wire and refined copper products in the Peoples Republic of China. It develops, designs, manufactures, markets, and distributes alternatives to pure copper wire, which includes copper clad aluminum wire and recycled scrap copper wire. The company is based in Danyang City, the People's Republic of China. As opposed to mining copper and producing copper products for re-sale they recycle copper and since it is not pure copper is much cheaper to produce and costs less to end users. This is particularly interesting since commodity prices, including copper, are so high. Additionally, the copper product in China has strong demand. Without getting into the details of how this works and the proprietary processes Lihua uses to produce their copper products (which can be reviewed at Lihua's website) let's get into why this may be a good value investment.
Balance Sheet:
As of December 31, 2010 (using fully diluted shares of approximately 30,800,000 including warrants) there is approximately $2.94 per share of cash on the balance sheet. In fact, total current assets are 4.55 per share. On the liability side of the balance sheet, total liabilities are just over $25 million with no long term debt. Therefore, cash net of all liabilities amount to $2.12 per share and current assets net of all liabilities is $3.74 per share. Therefore, we essentially get the business for $4.08 per share (based on the 4/15/11 close price of 7.82). Even if we conservatively say that the receivables (1.07 on a per share basis) are worthless, the business costs us $5.15 per share which is 3.99 times 2010 fully diluted earnings.
I am not taking into consideration any of the property, plant and equipment because the land is leased from the PRC and their machinery is custom made, thereby it appears the long-term assets are only worth the money they produce. So, let's take a look at the income statement.
Income Statement:
Sales have grown from approximately 50,000,000 in 2008 to 370,531,000 as of December 31, 2010 or 740%. Net income over this time has increased from 14,197,000 to 54,296,000 or 282%. Although shares issued and outstanding are 29,968,087 the fully diluted shares are approx. 30,800,000. 2010 net income translates to just under $1.29 per share on a fully diluted basis or 6.06 times earnings based on Friday April 15, 2010 closing price ($7.82). Further, the 4th quarter was the first including revenue from their recently-launched copper anode product line which totaled 26% of full year sales. They further received 2011 copper anode volume orders of 54,000 tons and an additional indication of demand from three additional customers for total demand of 80,000 tons. Problem is this exceeds current capacity. Good news is the recently launched production of a second copper smelter doubled capacity to 50,000 tons and Lihua additionally broke ground on a second smelting facility which is expected to be completed in 2H11 which will double capacity again to 100,000 tons.
Let's take a quick look at future growth. Currently, 2010 production capacity and Gross Profit was as
2010 2011 Copper Anode 50,000 100,000 CCA Wire 7,500 7,500 Copper Wire 20,000 20,000
Gross Profit GP % Copper anode 50,933,000 20.95% CCA Wire 8,507,000 8.71% Copper rod 2,661,000 8.93% Total 62,101,000
Keep in mind 25,000 tons of capacity for the copper anode came online during 2010 and another 50,000 tons of capacity is scheduled to come online is 2011. Therefore gross profit can increase by almost another $1 per share in earnings based on gross profit for the copper anode having earned $8.5M since August of 2010. Lihua has a couple of things going for it: (1) Increasing earnings and (2)a re-evaluation by the market on the valuation of the company, for instance, an increase in the P/E . At 10x earnings of $2 = $20/share ($1 of current earnings plus $1 as calculated above due to an increase in output from newly constructed assets).
Other than an increase in earnings the catalyst or the reason Lihua is so cheap is due to the way Lihua raised money. Lihua completed a reverse-merger with a public shell corporation. According to recent articles several Chinese companies have raised money this way and some are being investigated by the SEC for fraud. Therefore a stigma around these companies has driven down prices for many companies that raised money through a reverse merger. Therefore, the biggest risk is that the company is committing fraud makes no money and the entire investment wiped out.
That being said a couple of the ways a company commits fraud is through booking sales that do not exist or for sales to related parties. In either case, such fraudulent sales typically would show up as accounts receivable because such fraudulent sales would not translate into cash. Another possibility is that the cash booked on the balance sheet is overstated and fraudulent. I am sure there are other ways these are just a couple of ideas. However, the first procedure an auditor performs is through confirming cash balances with the banks. Therefore, unless the auditing firm is also committing fraud the cash on the balance sheet should actually exist.
Two things that I can think that may mitigate our risk with Lihua. The first is whether or not the auditor is reputable. The former auditing firm for Lihua was AGCA. I took a look at the "Inspection of AGCA" completed by the PCAOB who found deficiencies in AGCA's procedures related to accounts receivable and inventory valuation. This does not mean they were wrong it just means their auditing procedures performed were deficient in substantiating the value of these accounts. Additionally, if you look up other prominent accounting firms such as any of the Big 4 they also have similar types of deficiencies. At this point there does not seem to be a reason to doubt that the firm is reputable. The current auditing firm is Crowe Hogarth. Crowe Hogarth is a top 10 accounting firm. I took a look at the "Inspection of Crowe Hogarth" completed by the PCAOB and found similar results. It is hard to believe a firm completing fraud would make this type of move. Not that top accounting firms have not committed fraud in the past (think Enron and Arthur Anderson) but auditing standards are quite a bit more stringent now.
The second way we may be able to mitigate our risk is to take a look at accounts receivable in relation to sales. In other words, are the sales generating cash or are they only generating receivables. Total A/R net of the allowance for doubtful accounts (of zero) totals $0.82 of the share price. Even if all of the current net a/r on the balance sheet is fraudulent and these sales are deducted from full year sales and taken out of the product with the highest gross profit (copper and CCA wire) their net income would drop to roughly 8 million instead of $38.8 million. It seems either way they are at least making money, negating the risk that the entire investment would be wiped out. A .25 per share net income at 10x earnings would translate into a price of $2.50 per share based on earnings alone. Therefore, downside risk appears limited to $5.00 per share (current price less $2.50).
I would like to point out one additional analysis. I did not talk much about cash flow. The reason is the cash flow analysis per share I ran based on earnings less depreciation and amortization plus capital expenditures, for 2010, came out the same per diluted share as the earnings per share. This is in part due to a $9m payment to the PRC for a 50 year lease of land for the new smelting plant. Take out this $9m payment which is going to be amortized over the next 50 years will add another 0.25 per share of cash flow (35m diluted shared divided by $9m). As much cash as these plants appear to be generating free cash flow going forward should continue to increase as well.
Finally, there are some short sellers that have outlined why they believe Lihua is committing fraud. I will discuss such analysis in the next blog.
Disclosure: I, own shares of Lihua International, Inc. (LIWA, Financial). This report is not a solicitation to buy or sell securities. We are not responsible for any losses resulting from purchasing or disposing shares of Lihua International, INC (LIWA). You are advised to consult your financial advisor or conduct the due diligence yourself.
